Economic Growth – today, tomorrow and long into the future.

Economic growth is a key economic objective. Not only does it affect living standards, it affects productivity although there is discussion about whether productivity causes growth or vice versa. It is linked to the balance of payments with export-led growth being an ideal way of achieving two objectives yet  growth can worsen the balance of payments in both the short and long term; in the short term countries often have to purchase machines from overseas and build up raw materials and components and in the long run, particularly in the UK which has a high marginal propensity to import, higher incomes associated with growth cause significant increases in imports. It provides a fiscal dividend for the government, allows for a redistribution of income by channelling the rewards of growth towards low income earners and can allow the economy to expand in a non-inflationary manner by shifting the long run aggregate supply outwards although it is also associated with demand pull inflation when aggregate demand increases more than aggregate supply.

When analysing the causes of growth, economists differentiate between short run growth, usually associated with increases in demand, and long run growth which emphasises supply side policies. However recently there is a view among some economists that the developed world might be entering a period of prolonged stagnation. This was an idea first espoused in the 1940s but refuted by the post-war boom. Today the OECD are  predicting growth of below 3% among its members compared to 6% before the financial crisis and there is increased interest in the very long run.

Some suggest that today’s technological advances focus more on improving the quality of life and have a smaller impact on productivity than previous advances. However this is difficult to quantify since major developments, such as the internal combustion engine and electricity took over 50 years to work through the economy.

Another possible cause of the slowdown, if indeed we are entering a prolonged slowdown, is the fall in birth rates and increasingly ageing population which impact on the supply of workers and, possibly, on the development of new ideas. As well as the supply of labour being an issue, there are also concerns over increasing difficulties being faced in extracting raw materials as the world is having to use increasingly marginal sources. In the 1950s, one could extract the equivalent of 100 barrels of oil by expending 1 barrel while today the ratio is 20 to 1.

Some economists also suggest that not only are gains in long run aggregate supply increasingly difficult to achieve, old-fashioned reflationary policies are having a smaller impact than in previous years resulting in a weak recovery post 2008 throughout the developed world with the exception of the USA.

Does slow growth matter? Does faster growth and higher incomes bring greater happiness? Do the environmental advantages from a move to a lower growth path outweigh the benefits?

The Next Budget

Possibly, the Chancellor of the Exchequer, Sajid Javid, spent New Year’s Day in No 11 Downing Street, working on the budget which Boris wants ready for February when the UK has left the EU. If so, he will be aware that preparing the budget will be tricky because no one knows what the terms of the UK’s future trading relationship with the EU will be. Although Boris talked of a deal being signed in a year, business leaders and civil servants in the UK and many in the EU feel that this was unrealistic, given how long trade deals take to negotiate and the UK’s failure to reach the target for the number of trade deals promised during the referendum campaign. One can argue that, given the increase in protectionism in recent years, a close deal is vital, especially since the potential new markets are relatively small, compared to our trade with the EU.

Philosophically, the government has a potential  problem with the right of the Conservative Party favouring a free market approach with tax cuts and reduced regulations, while many new MPs elected in former Labour seats are looking for measures to help their constituencies which contained new Conservative voters, won over by the promise of Brexit, but whose jobs are at risk from increased competition from manufacturing companies in Asia, the loss of exports to the EU and a possible UK slowdown after Brexit. Many of these areas, with significant aerospace, chemicals and food production industries, rely heavily on exports to the EU and have to meet EU rules and regulations. If the future trade deal did not allow such exports to continue and instead allowed the EU to impose tariffs and implement customs checks, the consequences for some areas would be significant. The Flintshire and Wrexham area has an Airbus factory and a thriving pharmaceuticals industry and 87% of all goods made are currently exported to Europe. Elsewhere, in Derby North, where there is a Rolls-Royce factory, over 25% of the economy is linked to sales to the EU.

There is general agreement that the UK has spent too little on both business and infrastructure investment and encouragement for businesses to do the former and a determination by the government to do the latter will help improve UK productivity – a major UK issue. Incentives to help people, particularly first-time buyers, buy housing are important but, just as important as increasing demand, is the need to increase supply, possibly by encouraging more building on brown field sites. Another major area of need is the level of skills in the workforce and the need to bring UK vocational training up to the standards of other countries.

Fortunately, there is scope to boost the economy since the new government has adopted looser fiscal rules than its predecessor. In 2016, then Chancellor George Osborne’s fiscal rule was to eliminate the deficit by 2019/20 which was relaxed by Philip Hammond, who moved the target to 2025. What the current government has promised was to ensure that they raised enough in tax revenue to cover day-to-day spending but would borrow to invest. However infrastructure, such as building new roads, schools and hospitals takes time and very few projects are ‘shovel-ready’. This is worrying since growth started to stagnate and the labour market weakened before the election but possibly, following the clear election result, businesses and consumers might become more confident and increase their spending. Something to wish for at Xmas!

What sort of economy will the new Prime Minister inherit?

In elections, the economy is usually a key focus  on the campaign trail with opposition parties taking every opportunity to criticise the government while the latter explains how they have improved the economy after the disastrous state they found it in when they took office.

In this election, with its focus on Brexit and many lavish future spending plans, the current state of the economy has not yet featured heavily but were one asked to comment on its current state, it would be difficult since there is so much contradictory evidence at present.

Consider the following data and one sees why it is so hard to see how we are doing.

  • Although GDP grew by 0.3% in the third quarter of the year, the yearly growth of 1% is the lowest since 2010. Will this increase or fall after the election?
  • Unemployment is now 3.8% which, in historic terms, is low. However this is slightly up on the last month so does this, pessimistically, suggest we are on the cusp of an increasing period of unemployment, especially since unemployment is a lagged indicator – firms do not immediately reduce labour when demand for their products fall. Alternatively, one can look at the figures and note that the falling number of people in work is because part-time employment has fallen by more than the rise in full time jobs so, positively, more people are in “real” employment or have the part-time workers who have failed to find full time jobs simply stopped looking and left the labour force?
  • Productivity has only increased by 2.4% since June 2007. Before then the UK had averaged 2% per year, so we are producing over 20% less than we would have been had the trend continued. Possibly this is due to the long tail we have in the UK in terms of productivity with too many firms a long way below the best in their industry. How can this be improved?
  • Inflation fell to 1.5% last month because of lower gas and electricity prices but retail sales fell last month as consumers possibly lost confidence in the economic outlook for the next few months. Earnings are increasing at 3.6% so real incomes are rising at 2.1% but if productivity is static, then inflation will increase as firms’ costs rise.
  • UK exports have dropped, possibly because of Brexit uncertainty and the slower world GDP growth following the US-China trade war.
  • The public finances have deteriorated. Borrowing has risen by a fifth during the first half of the financial year, and in September was £9.4bn compared to £8.8bn last year and the national debt was £1.8tn at the end of the financial year ending March 2019, equivalent to 84.2% GDP. Therefore how will the political parties finance their announced increases in spending without considerable increases in tax or borrowing?
  • UK consumer debt is rising, standing at £59,441 per household in August 2019. What will happen when interest rates increase as they are likely to do if government spending increases significantly or if the economy enters a downturn when Brexit occurs? Are we heading for another financial crisis?

The Phillips Curve and the future of inflation

The Phillips Curve, named after A W Phillips, is a Keynesian idea suggesting that both unemployment and inflation are determined by the level of aggregate demand and there is therefore a trade-off between them. Phillips, writing in 1958, plotted UK rates of unemployment and wage inflation (which later economists replaced with price inflation) between 1860 and 1957 on a scatter diagram which showed an inverse relationship between the two. Economists did the same for other countries and a similar inverse relationship was discovered. This was because, as aggregate demand increased, firms increased prices, reducing some of the extra demand and obtaining higher profits. Simultaneously they hired more workers to meet the new demand, causing labour shortages which led to increased wage rises; there was also likely to be more demand for commodities and components, increasing their prices. Phillips’ relationship indicated that the trade-off worsened at higher levels of inflation and unemployment. For example, when unemployment is above average, higher demand, possibly as a result of government economic policy, will have a significant impact on the level of unemployment without significantly increasing inflation because of the excess capacity which exists. However, if unemployment is already low with firms close to full capacity, an increase in aggregate demand cannot easily be met by higher output and therefore prices are increased.

By the late 1970s, with many economies suffering from high inflation and high unemployment, something the traditional Phillips Curve deemed impossible, Monetarists questioned the validity of the Phillips Curve. Economists such as Friedman accepted that there was a short run inverse relationship between inflation and unemployment as suggested by Phillips but argued that in the long run, the trade-off did not occur and the long run Phillips Curve was vertical at the natural rate of unemployment – the rate at which inflation is stable. A key component in their explanation was the role of inflationary expectations. If inflation increases after a successful government stimulus to reduce unemployment, then gradually workers will ask for higher wage rises to compensate for the higher inflation and this will nullify the impact of the government’s policy, causing unemployment to return to its higher level.

In recent years many developed economies have been experiencing low inflation and low unemployment. In the UK for example, we have a 2% inflation target and it is not long ago that we thought the natural rate of unemployment was between 4.5% and 5%. Yet, today inflation is 1.7% and unemployment is at 3.9%. It is not just the UK which is performing well in terms of these two measures. The IMF estimates that of 43 countries with inflation targets, 28 are below their target rate. So what explains this phenomena? Or, to put the question in more theoretical terms, why has the natural rate of inflation fallen in so many countries, allowing them to operate with a low level of unemployment without the inflationary pressures which would have occurred in the past?

We can look at the positive impact of globalisation reducing costs in firms’ supply chains as components are supplied and goods are assembled more cheaply (with particular mention of the impact of cheap Chinese products); there is the benefit of  on-line shopping which has forced traditional retailers to cut costs and prices, reducing inflationary pressure and of technological change also reducing costs. Finally,  the impact of inflationary expectations, identified by Friedman to explain both high inflation and high unemployment, can  be applied to the current climate. When inflation is low and workers are used to very low or no wage rises, such increases become the norm and inflationary pressure falls.

What of the future? The positive impact of globalisation is declining, Chinese products are becoming more expensive and an increase in protectionism is pushing up prices. The future impact of technological change is unknown and it is doubtful whether on-line shopping will continue to reduce prices or whether we have been experiencing a one-off reduction in inflation.

Public Spending – The End of Austerity?

Cricket fans look forward to the Ashes, racegoers to the Grand National but for economists, the year has two highlights, namely when tax and public spending changes are announced. This is particularly the case for Keynesian economists who see the balance between taxation and government spending as the key determinant of the level of aggregate demand. Last week saw the Chancellor set out the government’s public spending plans for departments for 2020 – 2021. Possibly (and cynically) with an election looming, he announced the end of austerity with an increase of £13.4bn or 4.1%  in government spending. All areas would rise at least in line with inflation, with the main beneficiaries being the field of law and order (police, prisons and courts), defence, health and education. The increased spending will mean that the government’s share of GDP will increase for the first time since 2009.  The money for this will come from borrowing which is predicted to increase from 1.1% to 2.0% of GDP but, even with the increase, this keeps the public finances in line with the previous Chancellor’s target of cyclically adjusted borrowing of no more than 2% of GDP.

The spending announcement has raised eyebrows in some quarters. This is partly because of the process. Paul Johnson, Director of the Institute for Fiscal Studies, writing in the Times, pointed out that, normally, public spending reviews are a long process, with ministers arguing their case to the Treasury and big decisions being made in Cabinet. Given that the date of the announcement was made only a week before it happened, he wonders whether there has been sufficient time for a thorough review of all the conflicting demands on the government’s limited resources. Another concern among commentators is whether the Chancellor will be able to meet his fiscal rule. Last week’s announcement heralded the largest increase in spending since 2004 and it is worth remembering that in 2004, the UK economy was booming. Today the rise in spending comes at a time when growth is likely to slow. Therefore we can applaud the increase in terms of a counter-cyclical measure but expect that the 2% rule will need to be re-written in the next few months.